Introduction To Technical Indicators: A Trader’s Toolkit

Have you ever wondered how experienced traders predict price movements? Well, you’re in luck because today, we are going to guide you on how forex traders use technical indicators to get better returns on their trades. And this is not forgetting how it helps them better understand market psychology.

When used together, these indicators form part of your trading toolkit. In technical analysis , metrics such as trading volume play a crucial role in providing clues on whether an asset’s positive price movements will continue. In this regard, you can use these indicators to assist you in generating buy and sell signals.

Some of the best indicators to use when performing technical analysis for beginners include:

• Moving average convergence divergence (MACD)
• On-balance volume (OBV)
• Relative strength index (RSI)

While you may not need to use all three, you should make sure to choose those that you believe will be vital in helping you make informed trading decisions. You must remember that it’s only by using these tools that you can develop a disciplined trading approach. Without them, you may find yourself making emotionally driven trade decisions.

What Are Technical Indicators?

They’re mathematical calculations based on price, volume, or other market data. Technical indicators play a substantial role in providing objective insights, thus helping traders avoid emotional or impulsive decisions. Many of these indicators have been in use by traders for years, while others are still under development.

Chart Showing Two Types of Indicators: RSI and EMA. Source: Real Trading .

Understanding Technical Indicators

A technical indicator is defined as a mathematically derived calculation based on trading data. These calculations are based on asset prices, open interest, and volume and are important in allowing investors to gain objective insights in trading. Each indicator is weighed based on common sense, the investor’s objective, and historically adjusted data.

There are indicators that generate trading signals as stand-alone, and there are those that supplement each other. Traders use these technical analysis elements to evaluate the strengths or weaknesses of each security. They do this by focussing on price movements, trading patterns or signals, and other analytical charting tools.

While there exist non-specific technical indicators regarding the currency markets, there are those that can only be used for specified financial markets.

Why Technical Indicators Matter For Trading Success

At their core, technical indicators help investors spot patterns in price movements . Traders can better predict where a certain asset or commodity is headed next by analysing historical data such as momentum, volume, and price charts. This method is particularly beneficial for short-term traders such as swing traders and day traders.

These are traders who rely on rapid price movements to earn profits. However, you shouldn’t take this to mean that long-term traders can’t benefit from the same! All traders can use technical analysis to decide on the right entry and exit points. Put simply, technical indicators provide a roadmap for navigating the unpredictable nature of the forex markets.

Types Of Technical Indicators

Technical indicators, whether using a basic or complex mathematical formula, are typically represented in the form of a graphical chart. This chart can appear below or above the security’s price chart. Any trader can then compare the said indicator with the matching price chart of the security.

Below, we will introduce you to the four main categories of technical indicators, and will provide a brief explanation of how each works and how you can use it to trade.

Image source: StockCharts.com

Trend Indicators

These closely inspect the strength and direction of each trend by comparing asset prices to a predetermined baseline. Therefore, whenever the prices move above the average, this is interpreted as a bullish trend. And whenever the opposite happens, the investors interpret it as a bearish trend.

Trend indicators can thus be described as moving averages that you can use to identify market trends and reversals. You can then use them to setup corresponding support and resistant levels for your trades. Moving averages fall into two categories:

• Simple Moving Averages (SMA): It calculates the asset’s average price over a specified period, helping smoothen any price fluctuations that may arise. Seasoned traders use them to calculate potential entry and exit points, including emerging trends. When starting, you should try to experiment with diverse time frames to help you customise it to your trading plan.

• Exponential Moving Averages (EMA): This indicator is more responsive than the SMA, implying that it tends to give more weight to new price data. It’s, therefore, able to paint a better picture of the prevailing market conditions

Momentum Indicators

They measure the strength of an asset’s price movement in a given direction over a specified time duration. These indicators work best when used together with trend-following indicators and include the following:

• Relative Strength Index (RSI): Traders use it to evaluate the oversold or overbought conditions of the forex market, including potential price reversals. Its purpose is to measure the strength of an asset’s price action.

• MACD (Moving Average Convergence Divergence): As mentioned elsewhere in this guide, some indicators fall into several categories. MACD is an example of such and is an indicator that assists in visualising the relationship that exists between the two-trend following moving averages. You can use it to establish whether the momentum of a given trend is increasing or decreasing.

Volatility Indicators

These are a group of technical indicators used by traders to measure the probability of a sudden and often extreme shift in a stock’s price. They include the following:

• Average True Range (ATR): It’s a technical indicator that calculates the average price range of each asset over a given period. What you need to note is that the higher the ATR value, the higher the market volatility.

Bollinger Bands : They were developed by John Bollinger, and they work by plotting two standard deviations. These deviations are created away from the moving averages, producing “bands” that then track each asset’s lows and highs. Traders can use the Bollinger bands to identify potential trend reversals or breakouts.

Volume Indicators

As suggested by their name, volume indicators measure the strength of each trend based on the number of shares already traded. They include:

• On-Balance Volume: Traders use on-balance volume (OBV) indicators to identify divergences, support and resistance levels, and emerging trends. This indicator measures the level of distribution or accumulation by comparing volume to price.
• Chaikin Oscillator: Investors use it to understand the strength of buying and selling pressure in stocks. It assists them in making decisions related to potential confirmations and trend reversals.

Technical indicators have three broad functions: to alert, to confirm, and to predict.

How To Combine And Use These Technical Indicators Effectively

There are tons of technical indicators available in the FX markets today. Moreover, you can even create an indicator of your own, as opposed to relying on those already in use. However, many experienced traders choose to focus on a handful of these to help them avoid analysis paralysis.

So, how do you choose the right indicator to match your trading strategy?

• Start by considering your trading strategy. For example, if you’re a trend follower, concentrate on following trend indicators such as Bollinger bands and moving averages.
• Secondly, take a critical look at the market conditions . If you determine that the market has begun moving sideways, it won’t make sense for you to use oscillators or trend indicators.
• Lastly, consider your motivation for trading. For instance, if your objective is to buy and hold a given asset for an extended period, you may want to use a long-dated indicator.

Combining Indicators For Stronger Signals

Relying on a single indicator to make your trading decisions can prove risky. This is because this indicator may not always provide you with a complete picture of the existing market conditions. By combining indicators, you’ll get a more accurate insight into emerging and prevailing market trends. A few indicators that usually work together almost perfectly include:

moving Averages (Ma) + Relative Strength Index

The Moving Average indicator is best for identifying trends while the Relative Strength Index indicator assists traders in identifying overbought and oversold conditions. By combining these two indicators traders can quickly determine where price is likely to go next. For example, if the RSI is in the oversold territory and the 50-day Moving Avarages crosses above the 200-day MA. It could indicate an upcoming buying opportunity.

moving Average Convergence Divergence (Macd) + Bollinger Bands

The Moving Average Convergence Divergence indicator has a signal line, which allows traders to quickly know the overall trend of the market. When the market crosses above the signal line it indicates an upward trend and vice versa. On the other hand, Bollinger Bands consist of two standard deviations and a moving average line. The two deviations create an upper and bands that allow traders to identify possible reverals and high volatile markets or breakouts. So, how do these two indicators work together?

If for instance the MACD indicator signals a bullish crossover and the price goes below the lower bollinger bands, traders who use these indicators may be preparing to take a buy entry.

stochastic Oscillator + Average Directional Index (Adx)

The Stochastic Oscillator is mostly used to identify oversold and overbought conditions in the market. Anything above 80 is overbought and values below 20 are oversold. ADX, on the other hand, is made for measuring the strength of a trend. Values above 25 show a high ADX and anything below 20 is a low ADX.

Traders normally combine these two indicators to make an accurate entry. If the Stochastic Oscillator moves from overbought to oversold market and the ADX indicator is confirming a strong market trend, it could indicate that more sellers are coming into the market.

Traders should learn to rely on multiple indicators when trading to become consistently profitable. Using one indicator will not give you the results you are looking for because most indicators lag behind and may give false signals.

Avoiding Indicator Overload: Tips For Beginners

The key to using technical indicators effectively lies in understanding that no one indicator or tool performs well in all market conditions. Each tool or indicator will have its merits and faults. Therefore, you need to ensure that each indicator you employ has a purpose. It should provide a solution for the current market conditions.

The following two tips can help you avoid indicator overload:

• Be Terse with Your Technical Indicators: Most beginner traders start with moving averages and bar charts. While it’s okay to experiment with different indicators, you should avoid packing your screens with too many technical tools. Remember, the more tools you have on your screen, the more cluttered it will become, increasing its likelihood of freezing.

• Avoid Clutter for Clarity: Try to design your charts in a manner that will help you get the answers you need faster. For example, you can include an indicator that shows when a trend will emerge; a second indicator that shows when a change in the trend will happen, and a third which shows when it will be profitable to ride the trend to the end. These three indicators will serve your purpose without cluttering the screen.

Common Mistakes To Avoid With Technical Indicators

Trading with technical indicators has become a common practice among investors looking to gain insights from forex market data. But while indicators can guide you in making informed decisions, they can also lead to some common trading mistakes. Understanding these mistakes is crucial to learning how to avoid them.

Below is a look at some of these notable mistakes.

Over-reliance On Indicators: Why Balance Is Key

Over-relying on indicators without considering the broader market context, e.g., volatility, sentiment, emerging news, and fundamentals is among the most common mistakes made by traders when trading. Technical indicators are often derived from historical price data. This means that they’re likely to lag behind the prevailing market conditions. It also means that they’re unlikely to capture anomalies or sudden changes in the market. To avoid falling prey to this mistake, you should learn to use indicators as a guide rather than following them as a gospel. Make sure to combine them with analysis and other information sources.

The Dangers Of Overcomplicated Charts

Overcomplicating charts can lead to losses stemming from poor decision-making. A chart will not do you any good if you can’t use it properly to execute your trading strategy. It’s important to keep in mind that charts only show you what’s happening but can’t predict what will happen in the future. If you’re a day trader, overcomplicating your trading chart will likely lead to losses. Aim to keep the charts clean, and whenever possible, lean on basic indicators such as the Japanese candlesticks when making your decisions. It never hurts to be picky when choosing the indicators you wish to include in your charts.

Best Risk Management Practices For Traders

Even with the best technical indicators you may not be able to maintain consistency if you do not pay attention to risk management. Risk management allows you to protect your capital, giving you another opportunity to get into the financial market. Some of the best risk management practices all traders need to know are:

Position Sizing

Position sizing is whereby traders determine the amount of funds to allocate to every trade depending on their risk level. Traders are usually advised to risk only 1 or 2% of their overall capital for each trade. The advantage of this is that it limits excessive losses, allowing traders to continue trading for long even after experiencing some losses.

Risk-to-reward Ratio

Risk-to reward ratio is the amount of profit you want compared to the potential loss you are willing to take. A more favourable ratio is 1:2 or 1:3. A good risk-to reward ratio ensures that even if a trader takes a loss the profits are able to outweigh them, allowing the trader to remain profitable.

Avoiding Over-leverage

Leverage is normally described as a double-edged sword. This is because it can amplify your gains and also your losses. Beginner traders are advised to use low leverage because it minimizes the risk of potential losses and margin calls. A reasonable margin call ensures traders have full control over their portfolios.

Use Of Stop-loss Orders

A stop-loss order allows you to automatically close a trader to minimize loss on that particular trade. Without a stop loss, you could easily blow your account, especially in volatile markets. A stop-loss order is also vital for helping you keep your emotions in check.

Setting Realistic Goals and Limits

Setting limits and realistic goals is another risk management technique that is often overlooked. Having a monthly, weekly or daily goal allows you to limit your losses while ensuring your emotions are in check even after multiple wins or losses. Once your limit is reached, step away from the market and wait for another opportunity to revenge trading or over trading.

Conclusion & Next Steps

The goal of every forex trader is to attain trading success with indicators. Indicators such as RSI, MACD, and simple moving averages help determine the direction of a stock’s prices, allowing you to profit from these movements. Over the years, there have been dozens of oscillators and technical indicators developed for this specific purpose. In this guide, we have provided some of the most common and have included several beginner trading tips to help you get started. As you trade, try to explore specific indicators in detail and practice disciplined usage to enable you to become profitable. During the early days, it would be best to try a basic indicator, e.g., the moving average on your trade. Observe its effects on a demo account after implementation to build the confidence you need to trade on a live account. While practicing, do not forget the importance of risk management, as it allows you to protect your capital, ensuring you maintain profitability throughout your trading career.